So here’s a game I’m playing a lot lately: dueling
Greek. No, I’m not finally fulfilling my
father’s long-dead wish that I attend Greek School. It’s just that a lot of PE managers are
slinging the Greek around. Seven or
eight years ago it was really rare for an LBO pro or VC to describe themselves
as an “alpha” manager, but it seems commonplace today.
Of course, I understand what people are getting at. They’re suggesting that they’re after
improved risk-adjusted return. But
that’s where it gets dicey: how do you articulate risk in a PE context? And what’s the appropriate level of return
per unit of risk?
what’s your beta?” At that point, the
GP probably thinks that he’s got a smart aleck on his hands, but the question
is sincere. Really, it is! (I’m not one of those Dollar and a Dream
As we all remember, alpha is the excess return of a
portfolio relative to the return predicted by a portfolio of similar risk
(expressed as beta). Said more elegantly (note the gratuitous equation inserted to gain
credibility with the quants):
Portfolio alpha = Portfolio Return – (Risk Free Rate + Portfolio Beta * Equity Risk Premium)
So assuming a long-horizon nominal equity risk premium around
6.5% and an average nominal risk free rate of about 4.5%, a portfolio with a
beta of one should have a return of about 11% and anything above that is alpha,
sweet alpha. [We could quibble about
time-varying premia and risk free rates, but the generic point is valid,
no?] Here’s the catch: I just don’t
believe that PE betas are anywhere close to one; on the buyout side, higher
levels of debt implicitly raise beta while the venture guys have incredible
volatility of outcomes.
Fortunately, most folks decide to play along with the spirit
of the question and we typically get into good discussions of risk appetite,
tolerance, and management. It’s always a
stimulating chat, but people rarely answer my question directly. To be a sport, a GP once argued – with a grin
– that the beta had to be less than 1 because most people thought the
correlation of PE to the public markets was about 0.65. Without skipping a beat, he acknowledged that
appraisal effects and stale prices made that number totally meaningless.
So, what is the beta of PE?
Is it 1.25 (kinda like Vanguard’s small-cap Explorer fund)? Or more like 2.0? If it’s the former, you’ve got to generate
net returns greater than about 13% to have positive alpha; if it’s the latter,
your bogey is closer to 18%.
[Interestingly, the time-worn PE goal of 500 bps of excess return
probably implies a beta of about 1.75, which is
about the beta exhibited by some public managers with concentrated portfolios].
At this point – like Chevy Chase
playing Gerald Ford – I exclaim, “I was told there would be no math here,” so
why sling numbers around in search of a pedantic point? Because PE supposed to be a return enhancer
relative to public market alternatives (the opportunity cost of risk
capital). I’m finding that when people
say “alpha,” they typically just mean “top quartile,” and that’s not alpha at
all. Maybe “top quartile” will equal
positive alpha over time – I have my doubts – but right now it’s just a worn
marketing slogan. Don’t get me wrong, I
love firms who can outperform their peer group, but unless we can figure out
how to find the folks who are generating true risk-adjusted excess
return, we need to keep asking ourselves the question: why bother?